Toro
Diamond Member
But raises output and lowers real interest rates over the long-term. Also, lowering the deficit through tax increases is typically worse than by cutting spending.
For those who don't want to read the paper or the exerts below, the conclusions are as follows;
http://www.imf.org/external/pubs/ft/weo/2010/02/pdf/c3.pdf
For those who don't want to read the paper or the exerts below, the conclusions are as follows;
- Cutting the budget deficit will lower growth and raise unemployment over the next 1-2 years. The effects of cutting the budget deficit is to raise the rate of unemployment by 0.3% over two years.
- There is no stimulative effect from cutting the deficit.
- Cutting spending has a less negative effect than raising taxes. However, other policy responses - such as lowering interest rates - mitigate the effects of cutting spending.
- Cutting different types of spending has different responses. Cutting wealth transfer, i.e. unemployment insurance, has little if any effect, and may be positive. Cutting government consumption, i.e. firing government workers, has a negative effect. Cutting government investment, i.e. infrastructure or education, has the greatest negative effect.
- Cutting the deficit when interest rates are at or near zero most likely has a much worse effect than when interest rates are higher.
- Though negative in the near-term, cutting government spending is beneficial long-term because it lowers interest rates and lowers taxes.
Based on a historical analysis of fiscal consolidation in advanced economies ... fiscal consolidation typically reduces output and raises unemployment in the short term. At the same time, interest rate cuts, a fall in the value of the currency, and a rise in net exports usually soften the contractionary impact. Consolidation is more painful when it relies primarily on tax hikes; this occurs largely because central banks typically provide less monetary stimulus during such episodes, particularly when they involve indirect tax hikes that raise inflation. Also, fiscal consolidation is more costly when the perceived risk of sovereign default is low. These findings suggest that budget deficit cuts are likely to be more painful if they occur simultaneously across many countries, and if monetary policy is not in a position to offset them. Over the long term, reducing government debt is likely to raise output, as real interest rates decline and the lighter burden of interest payments permits cuts to distortionary taxes. ...
[F]iscal consolidation is typically contractionary. A fiscal consolidation equal to 1 percent of GDP typically reduces real GDP by about 0.5 percent after two years. The effect on the unemployment rate is an increase of about 0.3 percentage point after two years. The results are statistically significant at conventional levels. Overall, the idea that fiscal austerity stimulates economic activity in the short term finds little support in the data. ...
following main results emerge from the analysis:
•• Spending-based adjustments are less contractionary than tax-based adjustments. In the case of tax-based programs, the effect of a fiscal consolidation of 1 percent of GDP on GDP is –1.3 percent after two years. In the case of spending-based programs, the effect is –0.3 percent after two years, and is not statistically significant. Similarly, while deficit cuts that rely on tax hikes raise the unemployment rate by about 0.6 percentage point, spending-based deficit cuts raise the unemployment rate only by about 0.2 percentage point. However, as will be shown below, a key reason the costs of spending-based deficit cuts are relatively small is that they typically benefit from a large dose of monetary stimulus, as well as an expansion in exports.
•• Domestic demand contracts for both types of fiscal consolidation, but by more in the case of tax-based packages. In particular, in the case of spending-based measures, domestic demand falls by about 0.9 percent after two years, whereas the decline exceeds 1.8 percent in the case of taxbased packages.
•• A rise in net exports mitigates the impact of the consolidation on GDP in both cases. However, there is a considerably larger improvement in exports associated with spending-based measures than with tax-based measures, whereas imports fall more for tax-based adjustments.
Why are spending-based adjustments less contractionary?
Much of the difference is due to the response of monetary conditions to fiscal consolidation: interest rates and the value of the currency tend to fall more following spending-based consolidation. Existing estimates in the literature can provide a rough sense of how much of the difference in output performance stems from the difference in monetary conditions. The difference in interest rate responses between tax-based and spending-based fiscal consolidation is about 50 basis points in the first year. Meanwhile, the output cost for tax-based consolidation exceeds that for spending-based consolidation by about 0.3 percentage point in the first year and by about 1 percentage point in the second year. Therefore, for the difference in output outcomes to be attributable entirely to the different monetary policy responses, a 100 basis point rise in interest rates would need to reduce output by about 0.6 percent in the first year and 2 percent in the second. Such impacts are within the range of estimates found in the empirical literature, though toward the high end.26 Thus, it appears that the difference in monetary policy responses accounts for much, though probably not all, of the difference in output performance. ...
The results reported above suggest that spending-based measures are less contractionary than tax-based measures, but do the effects differ across different types of spending cuts? In particular, a number of studies, such as Alesina and Perotti (1995), predict that spending-based adjustments have relatively benign effects if they involve cuts to politically sensitive items, such as transfer programs, or government consumption, such as the public sector wage bill. The key idea is that cutting politically sensitive items may signal a credible commitment to long-term deficit reduction and that, in these cases, positive “non-Keynesian” confidence effects offset the negative “Keynesian” impact on aggregate demand. On the other hand, cuts to less politically sensitive items, such as government investment, might have weaker confidence effects. To investigate this possibility, we divide the spending-based adjustments into three groups: those that rely mainly on cuts to government transfers (31 percent of all spending-based packages), those that rely mainly on cuts to government consumption (46 percent), and those that rely mainly on cuts to public investment (9 percent). The estimated impact on output of these three types of deficit cuts provides some evidence suggesting that spending cuts based on cuts to government transfers are relatively benign. In particular, the point estimates indicate a modest expansion. For adjustments based mainly on cuts to government consumption or investment, the output costs are larger. However, the estimates ... are based on a small sample of observations for which we have details regarding the types of spending cuts implemented. Hence, these results should be interpreted with caution. In particular, even for the cases of consolidation based on transfer cuts, there is no strong evidence of expansionary effects, as the results are statistically indistinguishable from zero. ...
http://www.imf.org/external/pubs/ft/weo/2010/02/pdf/c3.pdf
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